Waltham Forest pension fund recently gave itself five years to divest of fossil fuel investments because of the associated risks. Paul Hewitt and Marcos Jesus Ramos Martin discuss the issues of stranded assets and the potential for LGPS to influence change.

Investors are giving increased attention to address both their impact on climate and their exposure to climate change related risks.

As an agency providing social responsibility performance ratings and risk assessments to owners and asset managers, Vigeo Eiris has drawn its clients and stakeholders’ attention to the major turning points ahead on the subject.

We observe that although companies’ engagement remains weak, leaders among them have made a breakthrough in their business models with the implementation of fossil fuel alternatives. On a scale from 0 to 100 (where 100 reflects the highest level of engagement) 4% of the 82 companies assessed in the energy sector on the development of alternative fuels and renewable energy sources obtain a score above 40/100.

With the Paris Agreement limiting the raise of global temperatures below 2° C, and aiming for 1.5°C, markets are forced to consider the financial risks that will result from changes in regulations, technology and market conditions.

A carbon budget of 1,000 gigatons (Gt) of CO2 was estimated by the Intergovernmental Panel on Climate Change (IPCC), of which 52% had already been burnt by 2011, with only 485 Gt left in the remaining budget. This figure contrasts with the world total reserves, which according to the International Energy Agency are equivalent to 2860 Gt CO2 – of which 762 Gt CO2 are held by listed companies and the remainder by governments.

The underlying argument is that fossil fuel companies are currently relying on the exploitation of existing resources and even actively prospecting for more, setting humanity on the path to unparalleled climate change levels.

The other driver is financial, which is where fiduciary responsibility is especially key. If the international agreement on climate change is met, only 485 Gt of CO2 can still be emitted as highlighted above, rendering a large quantity of current fossil fuel reserves unburnable (reserves equivalent to roughly one third of existing listed company fossil fuel assets).

In the transition pathway to a low-carbon economy, aligned with international climate change targets, these assets would become stranded by a combination of regulation, technological development and market conditions.

Why are stranded assets an investment risk?

Investment research is increasingly highlighting the unpriced risks of stranded assets in the fossil fuel sector. In its Reports of the Advisory Scientific Committee of February 2016, the European Systemic Risk Board warns that “if substantial climate change is to be avoided, a large quantity of fossil-fuel reserves and infrastructure is unusable”.

The OECD reports that according to the International Energy Agency’s (IEA) 2°C-compatible 450 Scenario, the amount of stranded assets will be of the order of $304bn by 2035 (IEA, 2014): $180bn for upstream oil and gas investments, $120bn for new fossil fuel capacity in the power sector, and $4bn for coal mining.

According to an analysis from HSBC, equity valuations could drop by 40-60% in a low emissions scenario, and bonds of fossil fuel companies would be affected by ratings downgrades resulting in higher rates to borrow capital, impacting their capacity to face their obligations and to refinance their debt.

Investment risks are not only financial in nature. Stranded asset risk management relates to fiduciary duty. In addition, a number of legal constraints are expected to arise in the future across different jurisdictions, as occurred in France where legislators have specifically targeted investors, requiring climate change risk management related reporting.

Aside from risk, there is investment opportunity. Too many investors, including local government pension scheme funds, conceptualise environmental, social and governance issues as risk management and only think in terms of screening and prohibition, missing out on the positive investment opportunity of successful transition.

The investment response

Thanks to factors such as funding strategy, investment strategy, stakeholder and beneficiary views there is no silver bullet to mitigating stranded assets risks. Return risks and investor responsibilities do not diminish even where investment may be passive or pooled. The main responses remain: divest, hold and engage, adjust risk and hedge – or a combination.

The divestment movement has received great media attention. A significant number of institutions around the world have committed to some form of fossil fuel divestment, including universities, foundations, pension funds, faith organisations and local authorities.

LGPS, as one of the largest 10 global sources of capital is well positioned to influence behavioural change. However, it is also true that in a transition pathway to a low-carbon economy the world will still need to rely on fossil fuels during a period whilst ensuring social prosperity and development, especially in developing regions.

According to the IEA and its 450 scenario $13.4 trillion of investments in fuel supply would still be required in the period 2015-2030.

Similarly, it has also been widely argued that divestment leaves unaddressed the pressing need for fossil fuel companies to adapt to change.

Vigeo Eiris latest review of the Energy sector –concluded in early 2016 – shows that out of the ten biggest oil & gas companies by market capitalization only four have improved their efforts in diversifying their activities to include alternative fuels and renewable energy sources compared to the 2014 review, whilst seven of them still present weak performances in this area with scores below 29/100.

Evaluation

In order to evaluate stranded asset risk, investors may consider future scenarios and the factors that may affect fossil fuel industry such as policy and regulation (carbon tax, support to RE), technological development (disruptive energy efficiency, energy storage, dropping RE prices) and factors affecting market conditions (macro economics, changes in social behaviours and expectations).

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